18/7/17: Greece in Recession. Again.

Per recent data release, Greece is now back in an official recession, with 1Q 2017 growth coming in at -0.1%, following 4Q 2016 contraction of 1.2%. Worse, on seasonally-adjusted basis, Greek economy tanked 0.5% in 1Q 2017. The news shaved off some 0.9 percentage terms from 2017 FY growth outlook by the Government (from 2.7% to 1.8%), with EU Commission May forecasting growth of 2.1% and the IMF April forecast of 2.15%, down from October forecast of 2.77%.

Greece has been hammered by a combination of severe fiscal contractions (austerity), rounds of botched debt restructuring, and extreme fiscal and economic policy uncertainty since 2010, having previously fallen into a deep recession starting with 2008. Structural problems with the economy and demographics come on top of this and, at this stage in the game, are secondary to the above-listed factors in terms of driving down the country growth.

In simple terms, this - already 10 years long - crisis is fully down to the dysfunctional European policy making.

In real terms, Greek economy is now down almost 3 percentage points on where it was at the end of 2000 and even if we are to assume that the economy expands 2.15% in 2017, as projected by the IMF, Greece will still end 2017 some 0.76 percentage points below where it was at the start of its tenure in the euro area.

Meanwhile, the 2.1-2.15% forecasts are likely to be optimistic. Past record shows that, so far, since the start of the crisis, IMF’s forecasts were woefully inadequate in terms of capturing the true extent of the crisis in Greece.

As chart above shows, with exception of just two forecasts’ vintages, covering same year estimates (not actual forward forecasts), all forecasts forward turned out to be optimistic compared to the outrun (thick grey line for April 2017).

Another feature of the more recent forecast is that 2017 IMF outlook for Greece factors in worse expectations for 2018-2021 growth than ALL previous forecasts:

The key driver for this disaster is the EU-imposed set of policies and the resulting policy and economic uncertainty. In fact, if we were to take the lower envelope of growth projections by the IMF - projections that were based on the Fund’s assumptions that the EU will live up to its commitments to accommodate significant debt relief for the Greek economy from around 2013 on, today’s Greek real GDP would have been around 20-21 percent higher than it currently stands.

All in, Greece has sustained absolute and total economic devastation at the hands of the EU and its institutions, including ESM, ECB and EFSF. Yes, structurally, the Greek economy is far from being sound. In fact, it is completely, comprehensively rotten to the core and requires deep reforms. But this fact is a mere back row of violins to the real drama played out by the Eurogroup, the ESM and the ECB. The nation with already woeful demographics has lived through sixteen lost years, going onto seventeenth. Several generations are either face permanently damaged prospects of future careers, or have to deal with demolished hopes for a dignified retirement from the current ones, and a couple of generations currently in lower and higher education are about to join them.

4/7/15: Timeline for Greece and Some Anchoring

Greece timeline for the weekend:

Greece has missed the IMF and ECB payments this week with both non-payments having potential for triggering a mother of all defaults for Greece: the ESM/EFSF loans call-in (EUR145bn worth of debt).

The EFSF/ESM decision so far has been to 'ignore' the arrears, noting that non-payment to IMF qualifies as "an event of default":

"The Board of Directors of the European Financial Stability Facility (EFSF) decided today to opt for a Reservation of Rights on EFSF loans to Greece, after the non-payment of Greece to the International Monetary Fund (IMF). Following the IMF Managing Director's notification of the IMF Executive Board, this non-payment results in an Event of Default by Greece, according to EFSF financial agreements with Greece."

Greece owes the EFSF EUR109.1bn in "Master Financial Assistance Facility Agreement" loans, plus EUR5.5bn in "Bond Interest Facility Agreement" loans and EUR30bn more in "Private Sector Involvement Facility Agreement" loans.

For now, EFSF decided not to call in loans, preferring to wait for Sunday vote outcome. Per EFSF statement: "In line with a recommendation by the EFSF's CEO Klaus Regling, the EFSF Board of Directors decided not to request immediate repayment of its loans nor to waive its right to action – the other two possible options. By issuing a Reservation of Rights, the EFSF keeps all its options open as a creditor as events in Greece evolve. The situation will be continuously monitored and the EFSF will consider its position regularly."

A 'No' vote in the Sunday referendum can change that overnight.

This adds pressure on Greece to pass a 'Yes' vote - a pressure that is most publicly crystallised in the form of ECB refusal to lift ELA to Greek banks. Athens imposition of capital controls (limiting severely cash withdrawals from the banks) has meant that the current level of ELA (CHART below) is still sufficient to hold the bank run, but the ELA cushion remaining in Greek banks was estimated at EUR500mln at the start of this week. Even with capital controls in place, this would have dwindled to around EUR250-300mln by the week end.

Again, a 'No' vote in the referendum risks crashing Greek banks as ECB will be unlikely to lift ELA any more. In an indirect sign of this, the ECB appears to be setting up swap lines and euro credit lines for EU member states outside the euro area. For example, as reported by Bloomberg, "European Central Bank is set to extend a backstop facility to Bulgaria and is ready to assist other nations in the region to ward off contagion from Greece, according to people familiar with the situation". Such a move is a clear precautionary measure to put into place firewalls around Greek system.

Meanwhile, here is a report suggesting that Greek banks are preparing for an aggressive bail-in of deposits in the case of a 'No' vote (assuming ELA cut off):

The Government denied the reports of preparations of bail-ins, and continues to insist that the banks will reopen on Tuesday, a day after the referendum results are published, but it is hard to imagine how this can be done (unless the banks start trading in drachma) without ECB hiking ELA, and it is even harder to imagine how ECB can hike ELA in current conditions.

Source: TheodoreZ

So far, public opinion polls in Greece show very tight vote for Sunday. The latest GPO poll has the "Yes" vote at 44.1% and "No" at 43.7%. Alco poll puts the “Yes” figure at 41.7% against 41.1% for “No”. All together, four opinion polls published yesterday put the 'Yes' vote marginally ahead, another poll fifth put the 'No' camp 0.5 percent in front. All polls results were well within the margin of error. At the same time, majority of polls also show Greeks favouring remaining in the euro by a roughly 75 percent margin.

REFERENDUM TIMELINE
Sunday 5th July:
Polls open – 0500BST/0000EDT
Polls close – 1700BST/1200EDT

First exit poll – Shortly after 1700BST/1200EDT

~20% of votes counted – 1900BST/1300EDT
~50% of votes counted – 2100BST/1600EDT
~70% of votes counted – 2200BST/1700EDT (markets open)
~90% of votes counted – 0000BST/1900EDT

Timeline source: Trading Signal Labs

The build up of tension ahead of the Sunday poll has been immense. Even international bodies are being convulsed by the potential for a 'No' vote. So much so, that, as reported by a number of media outlets, there was a major cat fight between European members of the IMF and other IMF board members.

As reported by Reuters at Wednesday board meeting of the IMF, European members of the board attempted to block IMF from publishing its analysis of debt sustainability for Greece.

Quoting from the report: ""It wasn't an easy decision," an IMF source involved in the debate over publication said. "We are not living in an ivory tower here. But the EU has to understand that not everything can be decided based on their own imperatives." The board had considered all arguments, including the risk that the document would be politicized, but the prevailing view was that all the evidence and figures should be laid out transparently before the referendum. "Facts are stubborn. You can't hide the facts because they may be exploited," the IMF source said."

If only European members of the IMF Board were as concerned with the reality of the Greek crisis on the ground as they are concerned with the appearances and public disclosures of that reality.

A neat reminder of how bad things are in Greece today, via @RBS_Economics

Source: @RBS_Economics

As numbers tell, Greece has posted one of the worst collapses in economy for any advanced economy since 1870, fourth worst for periods outside WW1 and WW2.


So what to expect?

• In the event of a 'Yes' we are likely to see a significant bounce in the markets from the current levels, with euro strengthening on the news in the short run. But real re-pricing will only take place when there is more clarity on post-referendum bailout agreement. The key risk to that outlook is that a 'Yes' vote can trigger early elections - which will (1) extend the current mess for at least another 1-2 months, and (2) put new sources of uncertainty forward - as outcome of such elections will be highly unpredictable. I do not expect the EU to re-start new deal negotiations until after the elections, which means that there will be mounting, not abating pressures on the Greek voters to vote in 'the right' Government, acceptable to the Troika.
• In the event of a 'No' we are likely to see serious run on the markets in Greece and some 'peripheral' states, especially Italy. Greek capital controls will have to be stepped up significantly. Euro is likely to weaken in the short run, especially if ECB aggressively moves to monetise risks via both accelerated QE purchases and lending to non-euro banks.

Beyond these two possible scenarios, everything else is in the realm of wild speculation.

8/12/2013: Exiting EFSF: Check.

So it's official - today we exited EFSF http://www.efsf.europa.eu/about/operations/ireland/index.htm

As I said on twitter: this is a big first step for Ireland. There are many more to be taken in the future, long future... from EFSF's perspective - we are not free until 2042...

What is worth noting in the above table is the extent to which the EFSF has already managed to restructure our debts - maturities extensions mean that the earliest repayment date - previously falling on 04/02/2015 now falls on 01/08/2029. That is a massive restructuring of debt, which, taken together with other changes, explains why we were able to avoid an outright default to-date.

Another thing to note: from my personal perspective, there is a sizeable chance, I and many of my friends (for some that chance is even greater), will not be here to toast the day when Ireland finally repays (or rather rolls over) the full EFSF debt. That's a 'generation lost'... right there... touch it... give it a hug... its us.

30/11/2012: Moody's downgrade ESM and EFSF

Moody's downgrade of ESM and EFSF: here.

The downgrade was driven by two factors:

1. Moody's downgrade of France - the second largest provider of callable capital in the case of the ESM and as a guarantor country in the case of the EFSF.
2. "Moody's view that there is a high correlation in credit risk among the entities' supporters is consistent with the evolution to date of the euro area debt crisis and the close institutional, economic and financial linkages among the major euro area sovereigns. As a result, the credit risks and ratings of the ESM and the EFSF are closely aligned to those of its strongest supporters."

Another point of interest: "Moody's acknowledges that the ESM benefits from credit features that differentiate it from the EFSF, including the preferred creditor status and the paid-in capital of EUR80 billion. However, in Moody's view, these credit features do not enhance the ESM's credit profile to the extent that it would warrant a rating differentiation between the two entities."

Update: here's a good take on some of the issues involved in the downgrade: http://dealbreaker.com/2012/11/efsf-conveniently-downgraded/

15/6/2012: Some probabilities for post-Greek elections outcomes

Some probabilistic evaluations of post-Greek elections scenarios and longer range scenarios for the euro area:

In considering the possible scenarios for Ireland’s position for post-Greek elections period, one must have an explicit understanding of the current conditions and the likelihood of the euro area survival into the future.

Short-term scenarios:

In my opinion, there is currently a 60% chance that Greece will remain within the euro area post elections, but will exit the common currency within 3 years.  Under this scenario, the ECB – either via ESM or directly – will have to provide support for an EU-wide system of banking deposits guarantees, and new writedowns of Greek debt, as well as full support package for Spain’s exchequer and banks. Ireland, in such a case, can, in the short term, benefit from some debt restructuring. Part of the package that will allow euro area to survive intact for longer than 6-12 months will involve increased transfer of structural funds to stimulate capital investment in the periphery, including Ireland.

On the other side of the spectrum, there is a 40% probability that Greece exits the euro area within 12 months either in a unilateral, unsupported and highly disorderly fashion (20%) or via facilitated exit programme supported by the euro area (20%). In the latter case, Ireland’s chances to achieve significant writedown of our debts will be severely restricted and our longer term membership within the euro area will be put in question. In the former case, post-Greek exit, the euro area will require very similar restructuring of debts and real economy transfers as in the first option above. Here, there is an equal chance that the EU will fail to put forward reasonable measures for preventing contagion from the disorderly Greek default to other countries, including Ireland, which would constitute the worst outcome for all member states involved.

Longer-term scenarios: 

In terms of longer horizon – beyond 3 years, the scenarios hinge on no disorderly default by Greece in short term, thus focusing on 80% probability segment of the above short term scenarios.

With probability of ca 30%, the coordinated response via ECB/ESM to the immediate crisis will require creation of a functional fiscal union. The union will have to address a number of structural bottlenecks. Fiscal discipline will have to be addressed via enforcement of the Fiscal Compact – a highly imperfect set of metrics, with doubtful enforceability. Secondly, the union will have to address the problem of competitiveness in euro area economies, most notably all peripheral GIIPS, plus Belgium, the Netherlands (household debt), France. As mentioned in the short-term scenario 1 above, growth must be decoupled from debt overhang and this will require simultaneous restructuring of real economic debt (corporate, household and government), operational system of banks insolvencies, and investment transfers to the peripheral states. The reason for the probability of this option being set conservatively at 30% is that I see no immediate capacity within euro area to enact such sweeping legislative and economic transformations. Much discussed Eurobonds will not deliver on this, as euro area’s capacity to issue such will not, in my view, exceed new financing capability in excess of 10% of euro area GDP.

The second longer-term scenario involves a 60% probability of the euro area breakup over 2-5 years. This can take the form of a break up into broadly-speaking two types of post-Euro arrangements.

The first break up arrangement will see emergence of the strong euro, with Germany at its core. Currently, such a union can include Finland, Benelux, Austria, and possibly France, Slovakia, and Slovenia. The remaining member states are most likely going to see re-introduction of national currencies. Alternatively, we might see reintroduction of 17 old currencies. Italy is a big unknown in the case of its membership in the strong euro.

In my view, once the process of currency unwinding begins, it will be difficult to contain centrifugal forces and the so-called ‘weak’ euro is unlikely to stick. Most likely combination of the ‘strong’ euro membership will have Germany, Benelux, Finland and Austria bound together.

Lastly, there is a small (10 percent) chance that the EU will be able to continue muddling through the current path of partial solutions and time-buying. External conditions must be extremely favourable to allow the euro area to continue in its current composition and this is now unlikely.

11/6/2012: ESM / EFSF : building a bypass to nowhere

A quick one. Why ESM+EFSF lending capacity can't take Spain 3-years of funding (if Exchequer funds are drawn)? Here's a chart from Bridgewater:

Estimates for banking sector needs of Spain alone are running on average around €250 billion, with some sovereign supports, this rises to €370-470 billion. This will more than top the €700 billion hypothetical capacity of EFSF/ESM funding. With full 3 years Exchequer supports, the above mid range estimate can rise to ca €550 billion. That scenario (rather benign, given the markets conditions) will leave EFSF/ESM with ca €150 billion of funds (assuming Cyprus and Ireland do not dip into the funds this year or next) and that is nopt enough to fund Italian deficits and debt redemptions for even 1 years.

As the song goes: So long and thanks for all the fish...

24/1/2012: Europe's Latest Non-Leadership on ESM/EFSF

Another heated non-debate is sweeping Europe. In the latest round of bizarre, outright Kafkaesque rhetorical contortions, European leaders are now engaged in a heated discussion on the 'enlargement' of ESM. Alas, the whole thing is clearly heading for the same outcome as Europe's previous rounds of 'solutions'. Here's why.

Recently, as reported in German press (here) Angela Merkel started to yield on the idea that the 'permanent' ESM fund should be increased from €500 billion to closer to €1 trillion by, among other things, allowing for concurrent running of existent €250 billion EFSF facility and the setting up of the new ESM.

Sadly, this 'solution' is really a complete red herring, despite all the hopes the EU is pinning onto it. In fact, it so much of a fake, the markets are simply likely to laugh their way through it.

The EFSF is designed to run out of time in the end of 2013. ESM is designed to start the earliest in mid-2012. Which means that even in theory, combined ESM/EFSF can last not much longer than 12 months. In practice, however, even this is not going to happen.

Firstly, EFSF is becoming increasingly funded through short term debt issuance and this means that as we hit 2013, the rate of EFSF paper maturing is going to accelerate. To roll this into longer-dated paper will require more than just re-writing the statutes of the EFSF. It will require EFSF raising funding at the same time as ESM is raising funding. The likelihood of this being a successful market funding strategy is zero.

Secondly, ESM capital basis of (meagre) €80 billion is not going to be fully invested on the initiation of the fund. Which means ESM even in theory is not going to come out on day 1 and borrow full €500 billion capacity. In practice, it can't be expected to raise even 1/4 of that in the first year of operations.

Which means that even running concurrently, EFSF+ESM duo will not constitute a fund with anything close to €750 billion capacity. And this means that European leadership is clearly in line for winning the Global Non-Leadership Prize again this year. IMF, insisting on the concurrent running of EFSF/ESM as well, is going to be a runner up.

13/12/2011: European Summit and Markets Efficiency

One thing that clearly must be disheartening for the perfect markets efficiency theory buffs (supposedly there are loads of them around, judging by the arguments from the 'State Knows Best' camp, though I personally know not a single one who thinks that markets are perfectly efficient) is the speed with which the markets produced an assessment of the Euro zone's latest 'Grand Plan'.

Frankly speaking, the ink was still drying on the last week's summit paper pads and it was already clear that the new 'Solution' is not a solution at all and that the Euro zone crisis is not about to be repaired by vacuous promises of the serial sinners not to sin in the future.

This blog highlighted back on the 10th of December (here) the simple fact that Euro zone is highly unlikely to deliver on its newly re-set old SGP criteria targets, no matter what enforcement (short of Panzer divisions) Merkozy deploy. And in a comment to Portuguese L'Expresso (see excerpts here and full text here) and elsewhere I have said that instead of resolving the debt crisis, European leaders decided to create a political crisis.

Many other observers had a similar assessment of the latest Euro Land Fiasco pantomime that was the Summit. And yet, despite the factual nature of analysis provided, I was immediately attacked as a token Euro skeptic and an Anglophile.

Now, more confirmation - this time from the EU Commission itself (presumably this too has evolved into a Euro skeptic and an Anglophile institution overnight) - that the propposed Merkozy Pact is (1) extra-judicial and (2) largely irrelevant to the problem at hand. Today's Frankfurter Allgemeine reports that the new Pact will be - per EU Commission opinion - part of an inter-governmental treaty, which is subordinate - in international law - to any European treaty. This, in turn, means that a country in breach of the 'quasi-automatic fiscal rules - 3%-0.5%-60% formula - can simply claim adherence to existent weaker rules established under the fully functioning European treaties. This, in turn, will mean that there can be no application of the new Pact rules.

Thus, the new Merkozy Pact is subordinated to the weaker fiscal rules under the SGP and any extra-SGP enforcement of these rules is subordinated to the SGP procedures. Can anyone explain how, say Italy, can be compelled to implement the new Pact, then?

Meanwhile, of the other 'agreements' reached at the Summit, the EFSF agreement represents the weakening, not the strengthening of the previous Euro area position. In fact, post Summit, the EFSF is about to lose its AAA status (as France is preparing to lose its own AAA rating). S&P has the EFSF AAA-backers on negative watch and under a review, Moody announced yesterday that it will be reviewing AAA ratings across the Euro zone and Fitch labeled the Summit a failure. And amidst all of this EFSF is going to remain about 1/3 of the size required to start making a dent in the Euro zone problems. That, of course, assuming it can get up to that level - a big question, given pending downgrade and previous difficulties with raising funds.

The third pillar of the Euro zone 'strategy' for dealing with the crisis - the permanent ESM - also emerged from the summit in the shape of a party balloon with a hole in its side. Rapid deflation of the ESM hopes means that even with 'leverage' option, the ESM will not be able to underwrite liquidity to Italy and GIP, let alone Spain & Belgium. Furthermore, there is a question yet to be asked of the European leaders. Fancying ESM at €500 billion might be a wonderful exercise in fictional narrative, but where on earth will they get these funds from?

The fourth pillar of the 'strategy' was the IMF merry-go-round loans carrusel. Now, recall that brilliant scheme. The IMF has strict (kind of strict - see here) rules on volumes of lending it can carry out. But Euro zone problems are so vast, the IMF limits represent a huge constraint on the funding it can provide to the common currency debt junkies. So the EU came up with an 'Cunning Plan'. The EU will lend IMF €200 billion (which EU doesn't really have) and the IMF can then re-lend EU between €800 billion (under old rules on IMF lending) or up to €2 trillion (under that new 'leverage scheme'). Note: IMF doesn't really have this sort of money either.

So a junkie will borrow somewhere some cash, lend it to his dealer-supplier, who will then issue junkie a credit line several times greater than the loan, so the junkie can have access to few more years of quick fixes. Lovely. When you think of it, the irony of the EU passing a new 'Discipline Pact' with one stroke of pen, while leveraging everything it got and even leveraging the IMF to get itself more debt with the next stroke of pen takes some beating in the land of absurdity.

But fear not. The IMF is not likely to engage in this sort of financial engineering. Not because its new leader, Christine Lagarde - who comes from the European tradition of creating massive fudge out of monetary and fiscal policies - objects to it. It is unlikely to do so because its other funders - the US and Japan and BRICs etc are saying 'No way, man' to the Euro zone's plans. The US expressed serious concerns that Euro zone's plan will lead to US losses on IMF funds, while Japan's Fin Min Jun Asumi said that Europe must create a functional firewall first, before any IMF involvement can be approved. He also stated Japan's support for US position.

And so we have it. Post-Summit:

• There is no effective new 'Treaty' or enforceable new rules
• There is no enhanced EFSF and the old one is about to lose all its firepower
• There is no feasible ESM
• There is no Euro-leveraging of the IMF

Oh, and the ECB is becoming increasingly non-cooperative too.

And amidst all of this, the newsflow gets only worse and worse for Europe's battered economies. Greece is now projecting GDP decline of 6% in 2011 and 3% in 2012. The new deficit projections for 2011 are at 9% of GDP or €2.6 billion worse than the annual budgetary forecast of 8.5% deficit. Ditto for Belgium, where 2011 deficit is heading for 4.2% of GDP - 0.6 percentage points above the budgetary target (€2.2 billion shortfall). And, of course, there is that post-boy of austerity - aka Ireland - where Government tax revenues are collapsing as data through November shows (see details here).

So reality bites, folks. Markets are clearly not perfectly efficient. But once they discover the truth about the Euro Summit, fireworks will begin.

2/12/2011: Euro crisis: wrong medicine for a misdiagnosed patient

There's been much talk about the fiscal union and ECB money printing as the two exercises that can resolve the euro area crises. The problem is that all the well-wishers who find solace in these ideas are missing the very iceberg that is about to sink the  Eurotanic.
 (image courtesy of the ZeroHedge.com):

Let's start from the top. Euro area's problem is a simple one:

• There is too much debt - public and private - as detailed here, and
• There is too little growth - including potential growth - as detailed here.

Oh, and in case you think that discipline is a cure to debt, here's the austerity-impacted expected Government debt changes in 2010-2013, courtesy of the OECD:

In other words, it's not the lack of monetary easing or fiscal discipline, stupid. It's the lack of dynamism in European economy.

Let me explain this in the context of Euro area policies proposals.

• The EU, including member states Governments, believes that causality of the crisis follows as: Loss of market confidence leads to increased funding cost of debt, which in turn causes debt to become unsustainable, which in turn leads to the need for austerity and thus reduces growth rates in the Euro area economies.
• My view is that low growth historically combined with high expectations in terms of social benefits have resulted over the decades in a build up of debt, which was not sustainable even absent the economic recession. Economic recession caused the tipping point in debt sustainability beyond which markets lost confidence in European fundamentals both within the crisis environment, but also, crucially, beyond cyclical recession. My data on structural deficits (linked above) proves the last point.

So while Europe believes that its core malaise is lack of confidence from the markets, I believe that Europe's real disease is lack of growth and resulting high debt levels. Confidence is but a symptom of the disease. 

You can police fiscal neighborhood as much as you want (and some policing is desperately needed), but you can't turn European economy from growth slum to growth engine by doing so. You can also let ECB buy all of the debt of the Euro area members, but short of the ECB then burning the Government bonds on a massively inflationary pyre, you can't do away with the debt overhang. Neither the Euro-bonds (opposed by Germany) nor warehousing these debts on the ECB balance sheet (opposed by Germany & the ECB) will do the trick. Only long-term growth can. And in that department, Europe has no track record to stand on.

Take Italy as an example. Charts below illustrate the country plight today and into 2016. I use two projections scenarios - the mid-range one is from the IMF WEO for September 2011, the adverse one is incorporating OECD forecasts of November 2011, plus the cost of funding Italian debt increasing by 100bps on the current average (quite benign assumption, given that it has increased, per latest auctions by ca 300bps plus).

As chart below shows, Italy is facing a gargantuan-sized funding problem in 2012-2016. Note that the time horizon chosen for the assessment of fiscal sustainability is significant here. You can take two assumptions - the implicit assumption behind the Euro area policy approach that the entire problem of 'lack of markets confidence' in the peripheral states can be resolved fully by 2013, allowing the peripheral countries access to funding markets at costs close to those before the crisis some time around 2013-2014. Or you can make the assumption I am more comfortable with that such access to funding markets for PIIGS is structurally restricted by their debt levels and growth fundamentals. In which case, that date of regaining reasonable access to the funding is pushed well past 2015-2016.

Government deficits form a significant part of the above debt problem in Italy (see below), but what is more important is that even with rosy austerity=success model deployed by the IMF, the rate of decline in Italian public debt envisioned in 2013-2016 is abysmally small (again, see chart below). This rate of decline is driven not by the lack of austerity (deficits are relatively benign), but by the lack of economic growth that deflates debt/GDP and deficit/GDP ratios and contributed to nominal reductions in both debt and deficits.

But the proverbial rabbit hole goes deeper, in the case of Italy. IMF projections - made before September 2011 - were based on rather robust euro area-wide growth of the first quarter of 2011. Since then two things have happened: 

1. There is a massive slowdown in growth in Italy and across the euro area (see here), and
2. Cost of funding Italian debt has risen dramatically (see the second chart below).

These two factors, imperfectly reflected in the forecasts yield my estimation for Italian fiscal sustainability parameters under the 'adverse' scenario.

The above shows why, in the case of Italy, none of the solutions to the crisis presented to-date will work. Alas, pretty much the same applies to all other peripheral countries, including Ireland.

Which means that the latest round of euro area policies activism from Merkozy is simply equivalent to administering wrong medicine in greater doses to the misdiagnosed patient. What can possibly go wrong here?

24/11/2011: Beggar thy citizens

Things are desperate on a new level across Euro area, folks. So desperate, the Euro leadership delusions have shifted up a notched from already feverish levels they reached before.

Until now, the talk was all about the miracle pills of first "The Firewall of EFSF" then "ECB rescue" + "Euro bonds", now the convoluted plans to underwrite the failures of the last decades are getting more esoteric and, oh so European, at the same time.

Recall the EFS 'Firewall' - launched at first with ca €275 billion in lending capacity, enlarged to €440 billion capacity, then planned for a 'leveraged' enlargement to €1 trillion capacity. Now, with realisation that (1) €1 trillion is no longer enough of a 'Firewall' once Italy caught fire and the rooftop of Chateau France is getting steamy too; and (2) There is no €1 trillion worth of international idiots (oops... err.. investors) willing to part with their money for the greater good of European 'solidarity' the EFSF 'solution' has fallen off the radar.

Next, enter the idea of the ECB rescue and Euro bonds. These too are largely problematic. The ECB 'rescue' option at this stage will have to involve €1.5-2.5 trillion worth of assets purchases - something that will be (a) costly (imagine what will happen to bonds prices if the ECB were to wade in with that sort of cash into the secondary markets) and (b) internecine to ECB's mandate and reputation (in other words, turning your Central Bank into the financial toxic waste warehouse will do to the Euro just what the PIIGS combined default can - destroy it). The Euro bonds option requires two impossible to achieve things: (1) finding idiots... err... investors willing to pony up even more cash than for the EFSF for an undertaking written against largely non-controllable borrowers with little prospect of achieving economic growth to sustain repayments of their debts, and (2) balancing the need to get another credit against the risk of destroying credit ratings (as Euro bond will in effect simply give Governments more debt and this debt will be senior to their own previously issued national debt). And, of course, the Euro bond idea requires much closer political integration first - something that will take years to deliver.

Smelling the rat... err... failure in the above magic bullets, some Governments are now desperate enough to resort to the classic European response to the crises: fleecing their own citizens to pay for their spending habits. Behold tax increases across Europe and Belgian plans to sell their unwanted bonds to their citizens (the story here). In the nutshell, the idea is that there are no idiots... err... investors out there willing to buy Belgian Government promissory notes (note: Belgium, of course doesn't even have a Government). So the solution - just as Joe Stalin did in the 1930s-1950s - is to sell these bonds to unsuspecting ordinary people of Belgium. To make the 'deal' even more egregious, the bonds are to be sold at a discount on the yields provided to banks purchasers. Not only will Belgian pople join the line of those who hold dodgy paper, cross-linked to their entire risk profile of living and working in Belgium and paying Belgian taxes, but they are expected to do so for less reward!

Priceless, really, folks. Comparable only to Irish Government 'Solidarity Bonds' and efforts to sell state junk to national pensions and insurance companies. In economics, there's a concept of policies that 'beggar thy neighbors' by shifting risks/costs/losses onto other countries via trade and investment restrictions, taxes and subsidies. In Europe, we are getting to the point of having 'beggar thy citizens' policies.

31/10/2011: Bailout-3: The Gremlins Rising premiers

What a day this Monday was, folks. What a day. Just 4 days ago I predicted that the latest 'Bailout-3: The Gremlins Rising' package by the EU won't last past January-February 2012. And the markets once again cabooshed my perfectly laid out arguments squashing my prediction.

As of today we had:

• Italian bonds auctioned last week at 6.06% yield for 10 year paper, the most since 1999. The yield was up from 5.86% at the auction a month ago which marked the previous record high. For Italy, given its growth potential and debt overhang, yields North of 5.25-5.3% would be a long-term disaster. Yields close to 6.1% are a disaster! But things were worse than that last Friday: the Italian Treasury failed to fullfil its borrowing target of €8.5bn to be sold. Instead, the IT sold only €7.9bn worth of new paper. Boom - one big PIIGSy gets it in the 'off-limits' region!
• Also on Friday, Fitch issued a note saying that 'voluntary' haircuts of 50% on Greek debt will constitute... eh... a default / credit event (see report here). Which kinda puts a boot into the softer side of the 'Bailout-3' deal. Boom - Greece gets it in the gut!
• Today, Belgians went to the bond markets and got rude awakening: Belgium placed €2.155bn worth of bonds along 3 maturities: 2014, 2017 and 2021. The country wanted to raise €1.7-2.7bn (with upper side being more desirable), so there was a shortfall on allocation. 10 year bond yields for September 2021 maturity are at 4.372% against 3.751% for those issued in September 2011. Belgium is yet to raise full €39bn planned for 2011 as it has so far covered €37.517bn in issuances to-date. it will be a tough slog for the country with revised deficit of 5.3% of GDP in 2012 (assuming no new austerity measures) and debt/GDP ratio of 94.3% expected in 2012. Boom - a non-PIGSy gets a kick too.
• Also today, Germany marched to the markets with €1.933 billion in new 12-month bubills at a weighted average yield of 0.346% and the highest accepted yield of 0.354%. On September 26th, Germany sold same paper at an average yield of 0.2418%. Today, Germans failed to allocate €67mln of bills despite an increase of 40% in yields in just 5 weeks. Big Boom - the largest Euro area economy gets smacked!
• And for the last one - per reports (HT to @zerohedge : see post here): Europe, hoped to issue €5 billion in 15 year EFSF bonds. Lacking orders, it cut issuance volume by 40% to €3bn and the maturity by 33% to 10 years. As @zerohedge put it: "But so we have this straight, Europe plans to fund a total of €1 trillion in EFSF passthrough securities.... yet it can't raise €5 billion?" Massive Boom, folks - mushroom cloud-like.

So here we have it, a nice start for the first week post-'Bailout-3: The Gremlins Rising'...

31/10/2011: Europe's latest blunder

This is an unedited version of my article in October 30, 2011 edition of Sunday Times.

This week was a fruitful and productive one for Europe’s leaders. Not because the battered euro block has finally produced a feasible and effective solution to the raging debt, fiscal and banking crises sweeping across the common area, but because they spent the entire week doing what they do best: holding meetings and issuing communiqués.

The latest plan, unveiled this Wednesday, shows once again that the EU remains incapable of actually doing what needs to be done.

The real European disease is debt. Too much debt. Based on the latest IMF forecasts and statistics from the Bank for International Settlements by the end of 2011, combined public, household and non-financial corporate debts will reach 280% of GDP in the US. In France, the Netherlands, Sweden and Belgium, this number will be closer to 330-335%, in Italy – 314%, in Greece – 290%, in Portugal 375%, in Spain 360%, and in Ireland a whooping 415%.

The composition of these debts, and in particular the weight of public sector debts in total non-financial debt overhang, may differ, but the end result is the same for all of the above. Per August 2011 research paper from the Bank for International Settlements, combined private sector debt in excess of ca 250% of GDP results in a long term (aka permanent) reduction in future growth rates. This reduction, in turn, puts under pressure the ability of the indebted states to repay their obligations.

Further compounding the problem, European banking systems have become addicted to Government bonds as a form of capital. In the past, this addiction was actively encouraged by the Governments, regulators and the ECB. With the latest proposals in place, we are likely to see even more Government/EFSF debt piling into the banks in the long term.

Having ignored basic risk management rules, banks across the Euro area are now fully contaminated with their exposures to sovereign bonds that are about as bad – from the risk perspective – as the adjustable rate mortgage borrowers in the US. Based on the second set of stress tests carried by the European Banking Authority this summer, Greek haircut of 75%, as suggested by the IMF, against the core tier 1 requirement of 9% will imply a capital shortfall of €180 billion. Failing to recognize this, the EU plan unveiled on Wednesday calls for just €100 billion recapitalization under a 50% haircut.

This, of course is far too little too late for Greece and for Europe overall. To bring public debt to GDP levels back to the point of fiscal stabilization (under 100% of GDP) will require ca 20% write-down in Portugal, 40% in Italy, and 30% in Ireland. Europe’s problem is at least €730 billion-strong. It can become bigger yet if – as can be expected – Greece fails once again to deliver on prescribed fiscal adjustment measures and/or the write-downs trigger CDS calls and/or the credit contraction triggers by the measures leads to a new recession. All in, Euro area needs closer to €820-850 billion in funding in the form of both rights placements, assets disposal, and government capital supports.

Now, factor in the second order effects of the above numbers onto the real economy.

Injecting €820 billion in new capital or, equivalently, providing some €1 trillion in fresh capital and bonds guarantees as envisaged under the EFSF proposals being readied by the European officials will increase broad money supply by 10%. This is consistent with long term ECB rates rising to well above their previous historical peak of 4.75% - triple the current rate. European banks trying to raise new capital and deleveraging foreign assets will saturate equity markets across Europe with capital demand. Reduced banking sector competition, pressures on the margins and higher funding costs will push retail rates into double-digit territory.

For European companies – more addicted to debt financing than their US counterparts and now competing for scarce equity investors against their European banks – this will mean a virtual shutting down of credit supply. Starved of domestic credit, European multinationals will aggressively divest out of the Continent and pursue jobs and investment growth in places where capital is more abundant – the US and Asia.

As Paul Krugman recently said, “The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.”

Sadly, Krugman is correct. European cure proposals to the crises are worse than the disease itself and the Wednesday’s proposals for dealing with the crisis are case in point.

Firstly, banks recapitalizations – first via private equity raising and bond-to-equity conversions, then via sovereign/EFSF funding – risks extending the recapitalization procedures into the second half of 2012 and simultaneously increase the risk premia on banks funding. In other words, credit crunch is likely to get worse and last longer. Most likely, this will require additional guarantees to ensure the funding market does not collapse in the process. The ECB balance sheet exposure to peripheral banks and sovereign debts – currently at €590 billion, up from €444 billion back in June 2011 – will become impossible to unwind.

Secondly, the insurance option for sovereign bonds issuance is likely to be insufficient in cover and, coupled with greater seniority accorded to EFSF debt can lead to a rise in yields on Government bonds. This, in turn, will amplify pressure on countries, such as Spain and Italy which are facing demand for new bonds issuance and existent debt roll over of some €1.3-1.5 trillion over 2012-2014.

Thirdly, leveraging EFSF to some €1 trillion via creation of an SPIV (Special Purpose Investment Vehicle) will create a nightmarishly complex sovereign debt structure.

Under leverage EFSF option, a country borrowing from the fund €1 billion will receive only a small fraction of the money directly from the fund itself, with the balance being borrowed from international lenders that may include IMF. In order to secure such lending, the EFSF will require seniority for international lenders over and above any other sovereign debt issued by the borrowing state. This will de facto prevent the EFSF borrower from raising new funding in the capital markets in the future.

In all of this, Ireland is but a small- albeit a high risk – player with the power to influence some of the EU decisions, especially those that matter most. Alongside the EFSF reforms and banks recapitalizations, the EU will require stronger fiscal and sovereign debt oversight measures, and ultimately closer integration.

The Irish Government should make it clear from the earliest date possible that Ireland’s participation in this process is conditional on three measures. First, Irish banks debts to the euro system should be written down to the tune of €60-70 billion, allowing for clawing back some of the funds injected into banks as capital and providing a stronger cushion for a households’ debt writeoff. Second, we should demand that the debt-for-equity swaps explicitly encouraged as the means for recapitalization of the euro area banks in Wednesday agreement be applied to Irish banks. These swaps can be used to further reduce previously committed funds and reverse some of the debt accumulated by the Exchequer (on and off its balancesheet). Third, Irish Government should make it unequivocally clear that we will veto any tax harmonization in the future.

On the net, European solutions unveiled this Wednesday are simply not going to work. In Q1 2012 the latest recapitalization of Euro area banks and Greece will run out of steam. Next time around, this will happen in the environment of slower growth and possibly a full-blown recession with Spain, Italy and Portugal all running into deeper fiscal troubles. The real price of Europe’s serial failures to deal with the crisis will be the real economy of the euro zone.

Box-out:

This week’s CSO-compiled Residential Property Price Index (RPPI) had posted another 1.49 percent monthly fall in house prices nationwide. Exactly four years ago, at the peak of residential property valuations, RPPI stood at 130.5. At the end of September this year, the index was just 72.8 or 44 percent below the peak. The misery of falling prices is now impacting not only hundreds of thousands of negative equity mortgage holders, but even the all-mighty Nama. Nama referenced its original valuations of the assets it took over from the banks to November 30, 2009. Since then, residential prices in the nation have fallen 29.5% and apartments prices (the category of property more frequently related to Nama loans) have fallen 33.9%. All in, Nama will now require a 35% uplift on its assets (55% for apartments) to break even, not including the organization’s gargantuan costs of managing its assets.

16/10/2011: Hot air balloon of G20 summits

Having by now grown accustomed to the vacuous and pompous non-statements from European leaders of the crisis, one could not have expected much from the G20 summit other than predictable verbal ping pong of the non-EU nations urging Europe to deal with the crisis and the EU representatives returning boisterous claims that the “solution” being presented are “robust”, “timely”, “resolute”, “breakthrough”-like, “decisive”, and so on. This is exactly what is going on.

This weekend’s G20 summit failed to provide for anything different. Here are just few points from the final comments by the participants. The sources are here (http://www.reuters.com/article/2011/10/16/us-g-idUSTRE79C74G20111016) and here (http://www.reuters.com/article/2011/10/15/us-g20-highlights-idUSTRE79E1DA20111015).

Per French Finance Minister Fracois Baroin, the Euro crisis "…took up a little part of our dinner last night. We presented ... elements of the global and lasting package which heads of state and government will present at the Oct 23 summit. It responds to the Greek issue, the maximization of the EFSF, on the level of core tier 1 with a calendar which will be coordinated by the heads of government for the recapitalization of the banks. It responds, naturally, on the governance of the euro zone... We still have a week to finalize it."

Extraordinary vanity and vacuousness of the statement is self-evident. The idea that the Euro area crisis – pretty much the only reason for G20 gatherings nowdays “took up a little part” is absurdly juxtaposed by the claim that the EU presented “elements of the global… package” for resolution of the crisis. And do note the language: “global package” and “lasting”. To the French, it is rather common to refer to anything that impacts them as “global”, but the stretch of terminology here is obvious – the ‘package’ will have to be about the euro zone. In other words, it is not even pan-European, let alone global!

And then there’s that “lasting” bit. Per report: “The [G20] communique urged the euro zone "to maximize the impact of the EFSF (bailout fund) in order to address contagion". EU officials said the most likely option was to use the 440 billion euro [EFSF] fund to offer partial loss insurance to buyers of stressed member states' bonds in a bid to stabilize the market.” Now, give it a thought. A ‘lasting’ package of ‘solutions’ will use temporary guarantees to buyers of distressed debt?! This begs two questions: (1) How on earth will such use of EFSF address the main problem faced by over-indebted nations, namely the problem of unsustainable debts? Guarantees will not reduce Greek, Portuguese, Irish, Italian and Spanish debts to sustainable levels. (2) If EFSF were to remain a €440bn fund, how can the said amount be sufficient to provide already-committed sovereign financing backstop through 2015-2017, supply funds for banks recapitalizations to cover the shortfalls on sovereign funding, provide additional backstop funds for the sovereign deficits in the future, and underwrite a new tranche of CDS-styled insurance contracts that will have to cover ALL of the debt issuance by the distressed sovereigns? Note: it will require to provide cover for all debt, not just maturities-specific issues in order for it to be meaningful and prevent massive amplification of upward sloping yield curve, leading to potential front-loading of new debt by the distressed states and the resulting dramatic rise in maturity mismatch risks.

Baroin went on to dig himself even deeper into the verbal hole: "I have to tell you in truth that the results of the European Council on October 23 will be decisive… We've made good progress [on Greece] with the German finance minister. There are points of agreement which are emerging rather clearly and we will have an agreement on this point, but it would be premature to say what accord will emerge on Oct 23." In  other words: the summit achieved nothing and we might not even get a resolution ready for October 23^rd summit.

On France position on Greek creditor haircuts: "We will find an answer. [Read: we have no plan] You know the French position which is quite clear: we will refuse any solution that leads to a credit event." So overall, there is no plan and any plan will have to avoid significant write-downs on Greek debt. Or in other words: we have no idea how to solve it, but any solution will be irrelevant, because France wants it to be such.

"Central banks will continue to supply banks with necessary liquidity, we will ensure banks have the necessary capital. This is a very important message central banks are sending." That sounds like ‘do more of the same’ and pray for a different outcome.

"We prepared ambitious decisions for Cannes including a list of systemically important financial institutions." Jeez, what a breakthrough. How about just checking http://graphics.thomsonreuters.com/11/07/BV_STRSTST0711_VF.html list - it’s pretty comprehensive and you don’t need a summit to get it.

My favourite court jester was also out in force with statements. EU Economic Affairs Commissioner Olli Rehn didn’t wait for too long to stick his foot into his mouth:

"The communique of this meeting rightly underlines the urgency and need for decisive action to overcome the sovereign debt crisis and restore confidence in our economies."

Sorry, but does the EU Commissioner still need another communiqué to underline the importance of resolving the greatest crisis his employer faced since foundation of the EU?

"The communique welcomes, since the Washington meeting three weeks ago, that in the EU the reform of the economic governance has been concluded."

What reform, Olli? When and how has it been ‘concluded’? And if the ‘reform has been concluded’, why on earth would you say there’s any ‘urgency to overcome the crisis’?

"It is a very important reform ... It will help us to prevent future crisis"

So that’s it, folks. EU will never have another crisis again. As soon as they can deal with the current one, that is. Which, so far, has taken… oh… like 3 years of wholesale destruction of European economies and wealth.

"Beyond these positive steps, and in order to break the vicious circle, ... we put last week on the table a comprehensive plan, a road map. I am pleased to say that this plan received today a warm welcome from our G20 partners" If so, Olli, why on earth would the G20 continue to urge action?

On the net, the ‘summit’ was just another hot air balloon floating up above the havoc of reality, heading straight into the hurricane. Good luck to all on board.

12/10/2011: Starting on the right footing

Two longer-term points to start the day (and renewing the EFSF debate) right, folks.

Point 1 - Global macro and long term - excellent posts today from the Guardian (here) and from barry Eichengreen for Project Syndicate (here) both dealing with EFSF as a non-solution to the crisis, regardless of the size. Both post, just as all other analysis I've read so far can benefit from one additional reality check. What happens if/when the EFSF in its enlarged form gets implemented?

The focus of everyone's analysis so far has been the banks and the sovereign yields/ratings. Let's take a peek further ahead, to say 2014. With EFSF in place, some €500bn+ of liquidity has been pumped into the markets. The banks have taken some significant share of recapitalization funds and dumped these into Government bonds, EFSF bonds, and risky assets around the world. The Governments, having received a boost from the sovereign bond markets via their own banks are back on track to 'stimulating' the economy and the households are now fully pricing in not only their still intact gargantuan debt levels, but also future Government-assumed liabilities in EFSF. The ECB balancesheet is loaded with EFSF paper and short-term lending is rampant, implying that unwinding short term liquidity supply becomes impossible for the ECB without risking a massive liquidity crisis in the banking system. Next trace of post-EFSF world is... stagflation in the Euro land:

• Banks rising capital means margins on loans will rise, while private investment capital is now being courted by the banks at the same time as the corporates go for more debt and equity.
• Governments borrowing resumed means rates are pressured up to sustain euro valuations, which means policy rates are supported to the upside.
• ECB coffers full of EFSF paper means policy rates are supported to further upside.
• States-supported banking sector in Europe means lending supply down, compounded by higher capital calls.
• Taxes on ordinary income and wealth up, means no growth, compounding interest rates effects, despite Government 'stimulus'.

With European economy bifurcated into state-dependent sectors kept alive via debt issuance and private sector economy still on the death bed, as rates creep up to (retail levels) double digits for prime borrowers,wat takes place?

1. Heavily indebted households are being squeezed on both ends of their budget constraint;
2. Heavily debt-dependent European corporates are desperately trying to raise funding via equity issuance which runs against banks looking for more equity investors. Resulting capital crunch puts any hope for recovery on ice.
3. ECB, unable to unwind short-term funding to the banks and holding vast supply of EFSF-linked paper keeps the rates higher than Taylor rule would imply.

The problem, is that absent a direct and robust writedown of private debts and some sovereign debts, and restructuring of the banking sector, EFSF or any other similar measure, no matter how large it will be, will not be able to break the dilemma of "either banks go bust or economy goes bust".

Which brings us to Point 2: What needs to be done in restoring the banking sector to health?

Instead of focusing on immediate funding and capital issues, we need to focus on the actual causes of the disease:

Cause 1: too much debt in the system (real economy) highlighted here.

Cause 2: insolvent banking institutions nursing massive losses going forward.

To deal with both we need a systematic approach to restructuring the banking sector and household balancesheets. The latter is a tough call - expensive and hard to structure. But it will be impossible without the former and via netting of balancesheets it can be aided by the former. So here's the broadly outlined roadmap for restructuring Europe's banking sector:

Resolving Euro area banking crisis requires bold and immediate action. An independent panel, under the aegis of ECB and EBA should review the operational, capital and risk positions of top 250 banks across the Euro area and independently stress-test the banks based on mid-range assumed scenarios of sovereign bonds haircuts of 75% loss on Greek bonds, 40% loss on Portuguese bonds, 20% loss on Irish bonds, and 10% loss on Italian and Spanish bonds. In addition, risk weightings must reflect specific bank's dependency on ECB / Central Banks funding. 

The banks should be divided into 3 categories based on this stress test assessment: Solvent and Liquid banks (SL), with post-stress capital ratios of 8% and above and ECB/CB funding covering no more than 15-20% of the assets, Solvent but Illiquid banks (SI) with capital ratios of 6-8% and ECB/CB funding covering no more than 30% of the assets, and Insolvent and Illiquid banks (II) with capital ratios below 6% and ECB/CB funding covering more than 31% of the assets base.

SL banks should be required to raise additional funding in the private markets and de-leverage post capital raising to Loans to Deposits ratio (LDR) of no more than 110% over the next 5 years. 

SI banks are to be restructured, stripping back some of the non-performing assets, reducing LDRs to 100% over the next 2 years and recapitalizing them through public injection of funds from the EFSF-styled vehicle warehoused within the ECB with a mandate to unwind the vehicle through a 50% writedown of liabilities to EFSF (debt write-offs via cancelation of some of the real economic debts held by these banks - debts of households and non-financial corporations) and 50% recoverable from the banks over the period of 15 years. Public funding for recapitalization must follow full writedown of equity and non-senior debt and partial haircuts on senior debt.

II banks are to be wound down via liquidation - their performing assets and deposits sold and non-performing assets written down against capital and lenders' liabilities (bonds). 

If followed, this approach will deliver, within 12-18 months a fully cleansed banking sector for the Euro zone and improve debt overhang in the real economy, while encouraging new banks formation and competition.